Nuances between the most common hybrid instruments used to finance Tech companies. The good, the bad and the ugly.
Author: Lucas de la Vega for Medium.
When hard times hit the Venture Capital industry old fashioned ways of limiting risk flourish. As Fred Destin anticipated, the return of the Barbarians has come and you should know the difference among the existing ways investors play the shell-game.
The cornerstone of all these is the Liquidation Preference. Liquidation preference starts being an issue in big Seed rounds or Series A when professional investors step in with substantial amounts of money and request a downside protection given the high valuation assumed. This is a threat for founders in mild-growth scenarios.
You should try to avoid anything beyond a 1.0x non-participating liquidity preference. Otherwise you will be onboarding an equity upside instrument with more downside protection than debt!
The devil’s in the detail, be aware of the implications of all terms and conditions. Declining the Term Sheet with the highest valuation could save your company in the long run despite you have given up some upside in the short term.
Debt becomes more attractive
As the equity environment gets tougher (valuation and conditions) and funds shift onto a profitability strategy debt becomes more competitive. Sifted dixit, founders are now thinking more and more about raising debt and other hybrid instruments.
In the current situation, debt may have similar implications on the downside scenario while expanding founders profitability and enhancing governance. Find below the most common hybrid instruments:
The Good, Venture debt
The cheap double-dip. This is a senior loan without personal guarantees from the shareholders. It is non-convertible; therefore the upside is limited to the attribution of shares in the company, 10%-25% (equity-kicker). See more on the risk profile here.
Interest range on the low-double digit figures and has linear amortizations of c.24–36 months including a 6–12 months of grace period. Against convertibles or shareholders loans, it has no governance rights.
However, this the eligibility for a Venture debt is limited to Venture backed companies which have good performance and a limited risk profile. Venture debt is often seen as a strong signaling for a future equity round.
The Bad, Convertibles
Could be offered by existing investors or newcomers to increase liquidity. Hint, this kind of financing could represent a Troy horse.
These subordinated notes are fully convertible in the next-round and generally present aggressive discounts (25%-50%) as they tend to avoid the valuation discussion and enhance short-term liquidity. They might also present a Cap and a Floor.
Interest rates range from 3 to 10% and present bullet structures with a certain maturity. From a risk-reward standpoint this instrument has the downside protection of debt (ex-amortizations) and is offered the same upside than equity.
The main point for using this kind of financing is generally the timing, they are quicker than any other instrument. They are only accounted as Net Equity when converted.
Convertibles had become very popular in BAs and Seed investments given the highly competitive landscape of funding at a very early-stage. They also offer a lot of flexibility in valuation but this could be a double edge sword.
The Ugly, Shareholders loan
Only subordinated to equity, it is always performed by current shareholders. It has a defined repayment schedule and interest rate, both in line with the company performance.
There are no market-standard terms given the link to the company performance. Interest rate could eventually be much higher than Convertibles or Venture Debt if the company positively outperforms. The conversion is generally an ad-hoc feature and could be up to 100% of the loan depending of the situation.
In practice, Shareholders Loan are used by current investors when the company is in difficulties as the funds can generally be accounted as Net Equity. They are not a good signaling for external equity investors as it shows up the lack of confidence from current shareholders (which could potentially invest into equity capital).
Hybrid instruments can vary from one to another these three are the most common. However, you may face many other hybrid instruments such as Mezzanine debt and/or Preferred equity each having different terms and conditions.
Whatever your next financing round is: Equity, Convertible or Venture debt. I strongly encourage you to take three steps:
- Model the waterfall of all possible scenarios
- Understand the interests and possible misalignments with your investors and current shareholders at Exit
- Ask for feedback about the newcomer.